In this column, we'll talk about the Foolish Flow Ratio and show you why it is so important in the evaluation of companies.

Imagine you run a business. Let's say that you sell office supplies to other businesses. Your source of revenue is your sales, but you have a number of places where your money goes out. Employees have to be paid, inventory needs to be purchased and be on-hand for sale, long-term loans have to be paid back, utility bills have to be paid — the list seems endless. All of these bills are dependent on your cash flow.

How can you keep the cash flow going? One way is to hold off paying the bills you have to pay for as long as possible, while collecting the amounts due to you for your sales as quickly as possible. Plus, if you can keep your inventory down and pay your suppliers after you've been paid, you are winning. Your suppliers are financing your business at that point. You aren't stuck with payments on a warehouse full of copy paper waiting to be sold.

There are a number of different ways we can see if a business is managing funds effectively. The Foolish Flow Ratio is one quick way that was developed by Rule Makers, and we think the best way, to calculate how well a business is managing its cash. Here's the Foolish Flow Ratio formula:

(Current Assets - Cash*)
(Current Liabilities - ST Debt**)

* Cash = cash & equivalents, marketable securities, and short-term investments
** Short-term Debt = notes payable and current portion of long-term debt

Unfortunately, you won't find this calculation done for you by any company. It's pretty easy to put in a spreadsheet, though, or even do with a calculator and the company's latest balance sheet.

Now, let's look at how the equation works.

If we had high inventory in our office supply business and no cash, our Current Assets would be high. If we paid all of our suppliers the moment we received inventory, too, our Flow Ratio would also come out high — and the lower that the Flow is, the better. So, this wouldn't be good. And think about what this means for you as a businessperson — assume you put all of your cash in inventory. How will you cover your other expenses? Where's your cash for further expansion? Worse yet, you may find yourself stuck with a load of pens, pencils, envelopes, and copy paper and no money.

If you were a bit more clever, you might decide to forgo that big order of envelopes. Let's say you kept your inventory down, and negotiated a 30-day payment period with your suppliers. Now your current assets have dropped, and your current liabilities have gone up, since you don't have to pay these people right away. Can we work this a bit better? Sure, let's put your customers on 15-day terms.

So, now your inventory is down. Your clients are paying you before your bills are due. You don't have to go borrow from your credit line anymore to fill up your warehouse — your customers are providing the money. As you do this, your Foolish Flow Ratio drops lower and lower, reflecting your better management of cash. Four things will make it go down, meaning improve:

  • Less Inventory
  • High Cash
  • High Current Liabilities
  • Low ST Debt
A business with a low Foolish Flow Ratio isn't tying up its money in inventory, has a good amount of cash, and typically isn't paying high interest payments. This is an excellent way to run a business, whether it is selling automobiles, manufacturing microprocessors, or running a home daycare center.

How do we determine if a Flow Ratio for a business is good or bad? Our Rule Maker criterion is that the Foolish Flow be less than 1.25. Let's see how some competing companies fare:

Foolish Flow Ratios: The low Foolish Flow Ratios are showing Nortel and Cisco as being stronger competitors to Lucent when it comes to cash management. The Foolish Flow Ratio is just one of the tools available to us in evaluation of companies, however, those of us who have been in business learn quickly that cash management is crucial, so the Foolish Flow Ratio is a good tool to employ when investing.

To discuss this column, visit us on the Drip Companies board linked below.

Suggested Links:
Rule Maker: Foolish Flow Ratio explained further
Drip Port: Pepsi Flows, Wrigley Sticks
Specials: Lessons from Lucent's Foolish Flow Ratio